My business partner Howard Lindzon just posted a fascinating article (I’ll link to it below)…
Howard’s a very successful investor, and in his post, he explores a question that he (and almost every other successful investor) gets asked often:
What’s the key to your success: skill or luck? And more importantly, can you prove it’s not luck?
Today, I’ll dig into this debate about skill vs. luck and reveal the truth behind it…
Then I’ll show how it can help you become a successful early-stage investor.
Skill vs. Luck
Many successful investors will tell you that their success is based on skill.
But how can we know with certainty?
This topic becomes even harder to decipher when we’re talking about early-stage investors…
That’s because, despite the fact that start-up investors can earn great sums of money, in general, their investments tend to fail more often than not. (Even the best start-up investors, like Howard, will have more failures in their portfolio than winners.)
But because their winners are so incredibly profitable, start-up investors can still earn enormous profits. For example, one of Howard’s investments was in Uber, the taxi company…
Essentially, for every $5,000 Howard invested , he earned $2 million.
Here’s another way to think about it:
Imagine you invest $5,000 into 50 different starts-ups—that’s a $250,000 portfolio.
Now imagine that 49 of those investments fail. In other words, you lost $245,000.
Well, as long as your final investment turns out to be an investment like Uber, you’ll still end up with more than $1.7 million. Not bad!
That example might make it sound like early-stage investing all comes down to luck. But the truth is more interesting than that…
What Is Luck?
A few years ago, I came across a speech given by Michael J. Mauboussin.
Mauboussin is the Managing Director and head of Global Financial Strategies at Credit Suisse, and he’s one of today’s foremost thought leaders on markets and investing.
According to Michael, if you’re trying to tell the difference between a task that requires “luck” and a task that requires “skill,” you just need to answer one question:
Can I fail at this task on purpose?
For example, let’s say you and I were betting on the outcome of a coin flip. Could I lose the coin flip intentionally?
I could not, because there’s no way to predict what will come up next.
And since the answer is no—I couldn’t fail on purpose—then this task is 100% luck.
But now let’s look at this topic in the context of early-stage investing…
Separate the Good from The Bad
Certain business ideas are just plain awful—in fact, I showed you a few last week.
And if you insist on investing in flops, you’re going to lose your shirt.
But like Mauboussin has taught us, if you can fail at a task intentionally, then being successful in that task is based on skill.
Therefore, being a successful early-stage investor is a skill—and like any skill, it’s one you can learn and get better at.
For example, we’ve now taught over 5,000 students our proprietary system for separating good start-up ideas from bad ones.
To avoid making “bad” early-stage investments, we rely heavily on data rather than emotion—and then we focus our efforts only on the investments with the most promise.
You see, as we’ve learned, certain indicators have been statistically proven to help predict a start-up’s chances of success.
For example, did you know that companies with more than one founder grow 3.6 times faster than companies with just one founder?
Or that start-ups that raise capital from a venture capital fund are 63% more likely to stay in business than a company that raises money only from individuals?
When we evaluate a start-up investment, we review 23 individual indicators. This is a skill we’ve learned and developed—and it’s one you can easily learn yourself.
Luck vs. Probability
But to be clear, even after all the careful analysis we do, some of companies we back will fail.
That’s simply the nature of start-ups.
Remember, start-ups are aiming to do something new, something different. And there’s no guarantee that things will work out according to plan.
Because the outcome of any early-stage business is unknown, some folks argue that start-up investing is all about luck…
But if it were all about luck, investors like Howard wouldn’t be able to make money so consistently, despite the fact that a good portion of their investments fail.
The reason these investors are consistently successful is because they use a strategy—a skill—to build their early-stage portfolio.
Here’s how it works…
Stack the Odds in Your Favor
Based on data from leading venture capitalists like Howard, and like Fred Wilson of Union Square Internet, here’s what a “successful” early-stage portfolio looks like:
- 40% of the investments will fail outright…
- 30% will be breakeven or modestly profitable…
- And 30% will return 5x to 10x or more.
Without boring you with math, let’s assume you make 10 investments, and you put $1,000 into each one. That’s $10,000 in total.
Based on the above, you’d earn a total of $33,000, for a return of 330%.
A Strategy For Success
The thing is, it’s challenging to make the odds work out with just 10 investments.
It’s like flipping a coin…
Every time you flip a coin, there’s a 50/50 chance of getting heads or tails. But just because you flipped heads the first time, there’s no guarantee you’ll flip tails the next. You could flip 10 times in a row without getting tails.
But if you flipped the coin 100 to 200 times, you’d start to see a 50/50 split between the two sides.
It’s the same thing with early-stage investing: to get the odds to work out, you need to invest in more than one or two companies. Statistically speaking, you need to invest in 25 to 50 of them.
That’s why you need to do two things when building your early-stage portfolio:
- Screen out the companies that have the highest statistical likelihood of failing…
- Build a diversified portfolio of 25 to 50 (or even 100) investments, so the probabilities can work themselves out as they should.
That’s the key to earning predictable profits in early-stage investing.
And if you get “lucky” enough to invest in a start-up like Uber…
Well, that’s just icing on the cake.
To read Howard’s original blog post on this topic, click here now »